Milton Friedman believed the best measure of the effects of monetary policy was the growth rate of measures of money supply. Central banks nowadays believe the best measure of monetary policy are cash interest rates. In my view a far better indicator is the effect of ‘monetary disequilibrium’.
This concept was first raised by the great philosopher/economist David Hume (without using the label). ‘Monetary disequilibrium’ is the gap between the supply of money and the demand for money. In a world in which economic entities take time to adjust, monetary disequilibrium has been found to influence the adjustment of household consumption, goods and services inflation, asset inflation and rates of interest.
This issue was sorted out theoretically by Archibald and Lipsey in the late 1950s and results estimated in models of various nations and eras by this author and Dr Clifford Wymer, starting from their work at the London School of Economics in the 1970s and later. Logically, the specific linkages encompass the growth rate of money and the effect of interest rates and is more general than the approach of Friedman and modern central banks.
It is also necessary to decide whether a nation has a fixed exchange rate or a flexible exchange rate or a hybrid exchange rate. With generally fixed rates any given nation will tend to adjust its rate of inflation to the average global rate of inflation. With a world of floating exchange rates, inflation in each country can be determined by each nation’s monetary policy. In a world of both fixed and flexible rates and partially flexible exchange rates (like the old occasional shifts of exchange rates in different nations at different times), analysis is complicated.
There are other complexities. In Australia, for example, the exchange rate was floated in 1983. This is generally regarded as a great success but several times the exchange rate has risen faster than the central bank was comfortable with and monetary policy reduced interest rates faster than appropriate for a clean float. In some cases, lower interest rates than consistent with a clean float raised inflation and created a perceived need to later raise interest rates.
This approach led the Australian central bank to later raise interest rates to slow the economy. With new leaders not so used to their jobs, rate hikes were overdone and created a severe recession that Treasurer Keating labelled ‘the recession we had to have’.
This experience leads me to recommend that it would be better to impose a tax on cash flowing into Australia. This would leave the basic benefit of a clean float and overcome the difficulty of juggling interest rates to modify the freedom of the floating exchange rate.
Another great blackspot is the problem of asset inflation. Successive governors of the Australian central bank told a board member when asked what they do about asset inflation: ‘We have no framework’.
As a graduate student the current governor, Dr Philip Lowe, wrote a nice paper with a more senior economist (Claudio Borio) arguing that, if asset prices were rising too quickly, interest rates might need to be raised. The precise words used are as follows: 'it may be desirable, in some circumstances, for monetary policy to be used to contain financial imbalances before they grow to large'. Article published in 2003, title 'Monetary Policy: A Subtle Paradigm Shift'.
He now seems to see this differently. A recent newspaper article reported: 'The Reserve Bank has rejected suggestions that it should be keeping the heat out of the housing market as it pours billions of dollars into quantitative efforts to keep the cash rate low and turn around the nation's economic retreat'.
Philip Lowe has 'signalled that ultra-low interest rates would stay in place even if a housing bubble started to return'.
'It would be inappropriate for us to target asset prices'.
'That's not our job and shouldn't be our job'.
My question of course is ‘Whose job is it?’
I commend this issue to Treasurer Josh Frydenberg to consider. My suggestion would be to get some of the many bright economists employed by the RBA to start working on the problem. Indeed, a senior retired politician once asked me ‘What do they all do?’ with cash interest rates locked in at 0.1 per cent and nothing to do but print money.
Fiona Prior examines a unique approach to alcohol. More here.